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Identifying the lifetime value of a customer is an essential step in understanding the dynamics of your business. It will change your view of acquisition costs and of the profitability of different segments of your business, add urgency to your retention strategy and cause you to think hard about working more effectively to generate referrals.

People talk about being in business for the long term and about how tomorrow's dollar is what is important but the behaviors don’t always match the words. Whether you are in a transaction business or a service business, your revenue per customer will almost always be potentially greater than your initial sale.

Many overlook the importance of going through the exercise of calculating the lifetime value of a customer. It can be complex, and it is something that needs to be done separately for each different segment of your business. The collection details may vary in different parts of your business, but the principles are simple and straightforward.

Calculating Lifetime Value

The calculation of Lifetime Value of a Customer starts with a calculation of the average gross margin from a representative group of customers for a twelve month period:

1. Revenues: identify the revenues for the last 12 months of a representative group of customers, ensuring that they were customers for the full 12 month period.

2. Gross Profit: calculate the total gross profit from those customers

3. Average Gross Profit Per Customer: divide the gross profit by the number of customers in the group to come up with the average

It then goes on to look at the length of time that your customers stay with you and multiplies that by the annual gross profit. A small change in this number can result in a significant change in the Lifetime Value number.

4. Customer Longevity: calculate the length of time you expect to keep a customer. The best way to calculate this is to look back at prior years to identify how long your customers stay with you. You can also overlay management forecasts, but it is wise to be prudent.

5. Lifetime Value: multiply Average Gross Profit per Customer by Customer Longevity to calculate the lifetime value of an average customer

Let's look at a simple example of a promotional products company that generated $1,000,000 in revenues last year at a gross margin of 35% from 50 accounts. If this company calculates that they keep their customers, on average for 5 years, then the calculation looks like this:

As I said earlier, this needs to be done separately for different segments of your business, and perhaps for different sizes or types of customer within a business segment. It is well worth the work involved.

Lifetime Value after Referrals

Another consideration in thinking about Lifetime Value is the number of referrals that you receive, and the considerable impact that this may have on the number….and on your business. The concept is that each customer will, on average, refer a certain number of other customers during their relationship with you, and this must also be factored into the calculation.

Again, this can be complex, and may vary in different parts of your business, but as with Lifetime Value, the principles are simple and straightforward. The data may be difficult to collect, but the components of the calculation look like this:

1. Lifetime Value: from above

2. Number of Referrals Per Year: the number of new business referrals in the year being measured from the same customer group as above that resulted in acquiring a new customer

3. Referrals Per Customer: the number of new business referrals divided by the number of customers in the group to produce the average number of referrals per customer

4. Customer Longevity: from above

5. Number of Referrals During a Customer's Lifetime: Referrals Per Customer multiplied by Customer Longevity

6. Additional Value: number of referrals/lifetime multiplied by the Lifetime Value determined earlier

Continuing with the promotional products company example, let's suppose that last year they generated 7 referrals from the 50 companies that made up their revenues at an average of 0.14 referrals per company per year. Based on their 5 year Customer Longevity, the adjusted calculation looks like this:

The value of referrals for this company boosts their Lifetime Value from $35,000 to almost $60,000. Each referral received is worth potentially $35,000 to them in Lifetime Gross Profit, and the value of building an effective system to drive more referrals will make an impact on their profitability out of all proportion to the work involved.

Conclusion

If you go through this exercise, it will make a profound change to the way that you look at your business. As I said at the beginning of this article it will:

1. Change the way that you evaluate cost of acquisition of new customers

2. Cause you to rethink some of the items in your marketing budget

3. Give you a much better appreciation of the different value of different segments of your business

4. Identify which segments of your business generate the most referrals

5. Allow you to focus on growing the areas of your business that have the greatest value

6. Give you a new perspective on the value of retaining customers

7. Change your appreciation of the value of having effective systems in place to drive referrals